Nadia Papagiannis: Hi, my name is Nadia Papagiannis. I'm the Alternative Investment Strategist here at Morningstar. Today I'm here with Ed Peters who is Co-Director of Global Macro Research at Managers AMG First Quadrant Global Alternatives Fund. Thanks for being with us here today, Ed.

Ed Peters: Thanks for having me.

Papagiannis: Thank you. So, Ed, your fund uses highly liquid derivatives to take advantage of market inefficiencies in stocks, bonds, and currencies. Your fund help up pretty well in 2008. So what kind of indicators were you looking at? What caused your fund to profit in 2008?

Peters: Well, there were two things. One is, unlike a lot of asset allocation funds, even long/short asset allocation funds like ours, we didn't have a big overweight towards stocks, which happened. Usually, we used a relative valuation measure between stocks and bonds. It's based on a sort of risk premia, a spread in expected return. When that gets wide, equities look good.

What happened in 2008 was that, because of deflation fears and flight to quality fears, a lot of people bought bonds. That drove down bond yields to very low levels. And it made equities look very attractive, based on this one measure alone. But, unfortunately, it didn't take into account the deflationary aspects of what was going on.

So, in this kind of environment, what you need, in a high volatility environment, is you need factors which also factor in sentiment. One of the things we use, for instance, is a volatility factor, one that looks at when volatility is increasing, it basically downgrades the valuation factor.

The other thing that happened, during that period, is we also do a currency model as well, which is long/short. The currency model, a lot of people, for many years, have done something called the carry trade. The carry trade worked for many years. That's when you buy the high-yielding currencies and you sell short the low-yielding currencies, with the idea that people are going to sell their low-yielding currencies and buy the high-yielding ones.

Unfortunately, the high yielding ones have high yields because they have a lot of uncertainty attached to them. You know, that's why they have high yields. When uncertainty increases, people don't want to have that uncertainty anymore, so they unwind the carry trade.

In our approach, in our currency model, during the turbulence, we were actually putting more weight on our evaluation model, which is a purchasing power parity model with some bells and whistles attached to it. That was the thing to do. It was basically an anti-carry trade, during that period. So that's one of the reasons, the other reasons, we did well in 2008.

Papagiannis: So your fund is intended to produce a low correlation to traditional investments. So then, how does that fit into a traditional portfolio then?

Peters: Well, a traditional portfolio should have a combination of things, as most people know. One thing is there should be market exposure. A lot of people think that because markets were down in 2008, maybe we don't want market exposure. We just want alternative investments which are supposed to be not tied to market exposure.

There are a couple of misconceptions there. The first is that alternative strategies do have negative years. There is a misconception that absolute return, or total return, means no negative returns and that's just not true.

Papagiannis: Or impossible [laughs] .

Peters: Or impossible, yeah, that's right [laughs] . It's impossible legally [laughter]. The thing you want, though, is you want -- when the alternative investment has a negative year, you want it not to be the same time that your other investments are having negative years. You don't want them all to be negative at the same time, like in 2008.

A true alternative investment would have no correlation, not necessarily a negative correlation, no correlation with the broader market exposure. But you do want the broader market exposure and the reason for that is that long positions, if they're done properly -- especially in equities -- should grow with the business cycle. So as the global economy grows, they should grow, too.

This built-in growth mechanism is something you don't get from alternative investments, which are not tied to the global economy directly. That's the nice thing about long investments. You should always have some long investments for basically keeping up with the global economy.

You also need to diversify against the down side and that's where the alternative investments come in. The amount of return on investments depends on how comfortable you are with them more than anything else. Certainly, in the case of global alternatives, where the volatility level is targeted at 12 percent, it's essentially the same as an equity investment, slightly less risky than many equity investments. It would be an equity alternative.

Papagiannis: Which means you would take a portion of your equity portfolio and invest it in this fund?

Peters: Right. You would expect, over the long-run, it would have similar returns. It just would have a lower correlation, so you would be more diversified. And, over the long-run, when that happens, it means that your long-run returns will be higher than if you put everything into equities.

So the ultimate thing would be to actually divide it half and half. You'd have half in alternative investments, and half tied to market returns. You just have to make sure that the market exposure part is also efficient. We do have the other fund, the Global Essentials Fund, the FG Global Essentials Fund, which is an efficient beta portfolio or an efficient market portfolio.

Combining that together with a true alpha portfolio, like Global Alternatives, is a good idea. The reason I call it a true alpha portfolio is because it is uncorrelated with markets. Alpha should be uncorrelated with market returns. If it's not uncorrelated with market returns, then it's not really alpha.

Papagiannis: So an alternative investment, at its best, should provide low correlation to your traditional portfolio, which is important to have, a traditional portfolio. But it also should provide a positive return.